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Despite floating rate cuts, the very long end of the fixed interest rate home loan market is springing to life. David Chaston examines what is behind the surge in popularity

Despite floating rate cuts, the very long end of the fixed interest rate home loan market is springing to life. David Chaston examines what is behind the surge in popularity

All mortgages are long term commitments.

You enter into a legal contract to repay the borrowed funds, plus the interest.

But it is the term over which you repay the loan that really determines your total cost, much more than the interest rate you pay. Take a look at the table below. A 7% interest rate over 20 years is much less expensive than a 5% rate over 30 years, on a whole-of-contract basis.

So it makes sense to first decide over how long you want to repay your mortgage, and if you are not someone who constantly looks back with regret, long term interest rate deals may be for you.

Some borrowers like the game of negotiating short term interest rates; some mistakenly think that is the key to a sustainable mortgage.

But for others, a set-and-forget arrangement is a lot calmer way to live, eliminating the recurring rounds of 'rate stress' that resurface every one or two years.

Looking back over the past 10 years, rates for all mortgage terms have ranged from a high of 9.45% to a low of 4.85%. History shows a very wide band of rate risk and uncertainty. In that timeframe, current rates are low and five year fixed rates are currently only 5.85%. There is little to suggest that the next ten years won't show a similarly wide range and inherent uncertainty.

Fixing your payments for a long time is attractive. In fact, new options have opened up that may mean you only have to think about an interest rate reset two or three times over the whole life of the loan.

Over twenty years, choosing a seven year fixed interest rate means you will only have to worry about it twice more.

And the new 10 year option from TSB Bank opens up the possibility of only having one extra rate reset to worry about.

Borrowing $300,000 average interest rate
Total interest paid over ... 5% 6% 7%
  $ $ $
15 years 127,029 155,683 185,367
20 year 175,168 215,830 258,215
25 years 226,131 279,871 336,101
30 years 279,767 347,515 418,527

So, what are the plusses and minuses of going long?

Let's look at it from different borrower perspectives.

1. First home buyer

These buyers make up about 6% of all new borrowers committing to 10% of all new borrowing according to the latest RBNZ data.

Around the initial stressful period of taking up such a big obligation, the option for long term certainty will appeal to many people, eliminating unpleasant upside interest rate risks. True, you may give up the possibility of some 'gains' from falling rates over the term, but risk-aversion and regret-avoidance may seem a better approach than playing the uncertain interest-rate game.

And the prospect of selling up and moving to a more family-friendly house may seem an inhibition with the prospect of break fees if you shift before the end of the interest rate contract ends. But that is unlikely to be a real risk because most institutions will allow you to shift the loan and its fixed rate to any new home you move to without cost or penalty. (Costs for recording the variation in security will probably apply however.)

2. Young family

Having moved from your first home, and now with your family income probably somewhat less, costs will be at the forefront of your thinking still. Lower payments will look enticing and both a longer borrowing period and a lower interest rate may seem options. But remember, your new young family is the ultimate long term plan. Minimising risks and staying with paying off the mortgage as early as you can will likely be a better idea. Lower weekly payments as a benefit are a myth from the perspective of a grown up family. Family life will have many bumps in the journey; suffering a potential rate-hike squeeze probably shouldn't be one of them.

3. Second rung buyer

Now you have brought up the kids to lead life pretty independently, you find they are still at home. You need a larger place! With a transferable long-term mortgage with a transferable long-term interest rate, that transition will go more seamlessly in the financial component.

4. Investor

These buyers make up about 18% of all new borrowers taking up an impressive 31% of all new borrowing commitments.

A long term interest rate commitment would likely be clear proof that the investor is not buying for short term capital gain, clearing away an uncertainty of taxes due.

And property investment should be about locking in as many of your costs that you can so all of the benefits of rising rents flow though to your cash-flow. Yes, you can 'actively' manage your mortgage costs by regularly shopping around. That will add redocumentation and legal cost, but it can be worthwhile. But it can also be a trap especially when rates are rising. The fundamental basis of residential property investment is to receive a long-term stream of income that is steadily rising and that works best when you can fixed as many costs as possible. Borrowing costs are often the largest uncertainty with most new investments starting with 65% or 70% of the purchase price borrowed. The option to fix the interest rate for seven or preferably ten years is something more investors should consider as part of their long term strategy.

5. Trusts

Trustees may find low long term rates attractive if they have a situation where there are decades ahead before the beneficiaries need access to the Trust's capital. Both the elimination of risk and the lower need to manage regular refixing may seem attractive aspects in some situations.

Some myths

There are many real estate myths and one is that chasing the lowest mortgage interest rate (or the lowest home loan payment) is a way to get the overall lowest cost. Another myth is that interest rates will always go down. Yet another is that people who 'know for certain' which way interest rates are going in the future have some special insight; they don't. The future will always be uncertain.

And while we are looking at myths, it is also not correct you will always be involved in break fees if you want to move house. You could be in some arrangements, but your existing loan and interest rate arrangements can follow you to a new property as you trade up. TSB Bank offers this facility as do other banks. But changed arrangements or new drawdowns can often involve redocumentation fees. Break fees only involve costs to banks when rates are lower 'now' than the loan you want to break. If you change banks in that situation, you most certainly will face such fees. 

The long term mortgage market

Floating rates are on the decline jerked lower by last week's RBNZ reduction in the Official Cash Rate (OCR).

Wholesale swap rates are also falling, especially at short end. And at the long end they are now also falling, but slower. That means the slope of the rate curve is getting steeper.

But it doesn't follow that long term rates are going up at present. They are not.

RBNZ data shows that long end fixed borrowing is suddenly springing to life. For the past two years it has averaged only $30 mln in total, and for the previous two years it averaged only $20 mln in an overall mortgage industry book of almost $200 bln. But the data doubled in March, and almost doubled again in April. May data is due at the end of this month and will no doubt show another strong rise.

Despite the relentless focus on the short end, the long end is on the move as well, rapidly gaining in popularity

These are the interest rates borrowers with an eye for long term fixing are looking at:

Long term fixed rates 5 years 7 years 10 years
  % % %
5.79    
ASB 5.65    
5.75 5.99  
5.69    
HSBC 5.60    
Kiwibank 5.60    
SBS Bank 5.35    
5.85   5.95
Westpac 5.79    

(These rates are correct as at Monday, June 22, 2015.)

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4 Comments

Good points. The 2nd or 3rd rung etc buyer often starts a new mortgage rather than porting existing mortgage or keeping same term - so then households keep a mortgage longer, into their 50s & beyond. Added to the topup trap.
Interesting world when in the span of 25 or so years, interest rates have ranged from 21% to 4.8%.

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"There are many real estate myths and one is that chasing the lowest mortgage interest rate (or the lowest home loan payment) is a way to get the overall lowest cost."

Not sure how it could be a myth when there really is only 2 significant factors for a typical borrower. How much principal you repay and what interest rate you are charged. The lower your average interest based on your repayment term the lower the overall cost.

"There is little to suggest that the next ten years won't show a similarly wide range and inherent uncertainty."

Correct. So the only logical conclusion should be that you should seek the best terms available at a given point of time. The rule of thumb that I apply whenever my mortgage comes up for renewal is to lock in at the lowest rate available for the shortest term possible.

How did this turn out for me? Started with 620k mortgage in July 2011, now 360k as at June 2015. Average interest rate during that time 5.02%. Average is likely to drop below 5% this renewal as I have a 4.75% set up to go if interest rates hold. Yes it could of been lower - but I believe my approach is sound given that I didn't have to do any special planning or put much effort into it.

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A great strategy which works really well in a falling or stable market situation chasing short term and lowest possible rates - if you apply the same strategy in a rising market - say heading back to the 8.5 and 9% rates pre 2008 - its a very expensive and ineffective strategy compared to taking a five year fix now.

Ultimately its not just cost that needs to be factored in - also risk and security - likelihood of moving - ability to handle swift or significant changes in rates. If for example you can possibly pay a rate of more than 6% - then a five year fix under that offers huge protection and security and five years to increase income and decrease mortgage.

The rates above are carded only - and further discounts are available on these five year fixes - and I for one have a split policy - I have a large amount just going into a new interest only 5 year fix at 5.4% - money that I cant reasonably hope to pay off in the next five years - and then amounts about half of that on shot term repayments and revolving credit - which I can feasibly repay in this period - but can manage comfortably if rates head back up and I end up paying 7 or 8% at the end of the loan.

Note I am not trying to perfectly second guess the market - simply find the best strategy for my circumstances - that makes financial sense

I also have a rental in Hamilton - which is fantastically cash flow positive - ROI over 20% - yes these do exist - which may well benefit from capital gains in the long run - after Auckland pops!!

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"real estate" =/= purely "borrower" costs.
Your "lowest rate, shortest time" ties into the finance providers expectation. If they putting very small rates on short terms (90days - 1 year) especially if there are "specials" then it means they are low now but expect high volatility - you might find your short term fixed exiting straight into a high fix/floating period. So you do have to do your homework. Often it is better to take a 18 month/2/3 year rate, and then break it on the last couple of months.

Likewise if you know you're going to be committed for a long period to getting your yield, it can be better to take a 7 year rate just for the security aspect, then breaking to a floating if you are convinced there a dive coming - if you do it when the floating is around your 7 year inital Fix point, your break cost will be minimal, then you can refix on the lower rate.

Also keep in mind that transactional costs are very real, especially those of stress and time. Interest on a house is a perfectly valid business financial cost, so is deductible - BUT interest is only one cost therefore it follows that the overall gross yield must be higher that the interest rate. (often done by sacrificing yield on the owners own equity while the principle is paid down).

So it is likely that interest rate is only a small part of the operation, and fixing it at a reasonable point, rather than chasing "two in the bush" of a perfect point at the perfect time, actually ends up costing less when allowing for transaction costs, as long as the interest interest cost) is more important than chasing the one less flexible aspect (deductible interest)

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